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Foundational Trading Knowledge / Understanding the Stock Market 28 / 32
Stocks vs Bonds: Top 5 Differences & Investing Tips

Stocks vs Bonds: Top 5 Differences & Investing Tips

2020-05-28 10:58:23
Warren Venketas, Markets Writer
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Differentiating between the stock market and bond market can help investors appropriately allocate their funds based on their goals and risk tolerance. After all, a diversified portfolio is generally recommended by market professionals under the same logic of not ‘putting all of your eggs into one basket.’ This is because investing in different financial instruments that each react differently to the same event can help to smooth out risk-adjusted returns rather than being solely dependent on the performance of a single asset or asset class.

This article will explore the differences between stocks and bonds in depth, covering:

  • A basic overview of the two investment options
  • Five key differences
  • How to invest in stocks and bonds
  • Stocks vs bonds FAQs

Stocks vs Bonds: An Overview

Stocks and bonds portray two different ways for entities to raise capital for its operations or expansion. To begin the journey of comparing these two investment options it is important to firstly understand their foundational concepts and definitions.

What are stocks?

A stock is a defined as a stake/ownership within a company which is bought and/or sold on an exchange. Buying a stock comes with the potential of a higher future stock price and dividends.

Read more in our beginner’s guide to stock market basics

What are bonds?

Bonds are issued by governments and corporations to raise capital and these instruments are traded over-the-counter (OTC). When an investor buys a bond, this is essentially a loan to the issuer who in turn agrees to pay back the face value of loan on a specified date along with regular interest payments called coupons (% of the face value), at prearranged intervals.

Top 5 Differences Between Stocks and Bonds

Outlined below are five differences between stocks and bonds which show the variety in the two investment vehicles, which can appeal to investors:

StocksBonds
1.Traded on exchangeTraded over-the-counter (OTC)
2.Represents ownership investmentsRepresents debt securities
3.Exposure to corporationsExposure to governments, corporations and financial institutions
4.Considered higher risk than bondsLow risk
5.Repayments include dividends which are not always certainRepayments are at a fixed rate which is guaranteed and backed by the bond issuer

1. How they are traded

While stocks are traded on a centralized exchange such as the NYSE or LSE, bonds are primarily traded OTC which means there is no formal exchange; but these instruments are traded and negotiated between parties. The bond market is therefore seen as less transparent to the stock market as bids to buy/sell are not seen by all market participants in the same manner that they generally are for equities.

2. Ownership

Stocks represent an ownership in a listed company, while bonds are seen as a debt instrument. That is, bond investors are returned the full amount of their original principal, except for the rare occasion when a bond defaults.

3. Exposure for investors

Stocks give exposure to many different stock sectors. However, this generally excludes governments, although stocks can be influenced by government decisions. Bonds offer investors exposure to governments (government bonds), corporates (corporate bonds) and financial initiations (financial institution bonds).

4. Investment risk

Historically, bonds are deemed to be lower risk investments due to their low percentage of defaults and guaranteed interest payments and return of principal. Stocks on the other hand do not provide a definite stream of income. This does not mean stocks are always riskier than bonds as corporate bonds, particularly ‘high yield’ or ‘junk’ bonds, can be risky as well. Continue reading for more insight into the risks related to investing in stocks and bonds.

5. Return

Bonds provide investors with fairly certain returns by means of interest payments which often appeal to the risk-averse investor. Stocks can offer larger returns through dividend payouts plus share price appreciation, but these dividends are not always guaranteed. This is because companies are not obligated to issue dividends to shareholders, and can eliminate or decrease dividend payments at any time.

Risks associated with stocks and bonds

Simply understanding what stocks and bonds are is not enough to make sound investment decisions. Being familiar with the risks involved with both financial instruments can help investors align their financial goals with the applicable instrument. Below is a tabulated summary of the associated risks with stocks and bonds:

StocksBonds

Interest rate risk

(cost of borrowing increases)

Interest rate risk

(inverse relationship with bonds)

Legislative risk

(relationship between governments and businesses e.g. taxes, new regulations etc.)

Reinvestment risk

(reinvesting proceeds of bond into another bond with a lower yield)

Obsolescence risk

(company becomes ‘old’ or the service/product is no longer desired)

Default risk

(inability of bond issuer to pay interest payments or principal amount to bondholder)

Headline risk

(effect of media on the business)

Inflation risk

(general price increases in the economy drops the return of fixed rate bonds)

Stock liquidity risk

(ease of buying and selling stock)

Credit spread

(the widening of spread is the widening in yield, which can indicate a slowing economy where the likelihood of default rises)

It's important to note there are other inherent risks which should not be overlooked when conducting investment research. Learn more in our guide to mastering effective risk management.

How to Invest in Stocks and Bonds

Stocks and bonds can be accessed through a variety of avenues. The financial markets have become so complex that investors are spoilt for choice; with the option of investing in tailored instruments that meet their financial goals and budget restraints.

Investing in stocks

  • Physical share dealing: Stocks can be invested in via physical share dealing which allows investors to purchase stocks in the hope that prices rise, after which they can be sold for a profit (or a loss in the event that share prices fell). This type of investing is not leveraged which can help to limit downside risk.
  • Leveraged share trading: Involves trading shares through leveraged or levered vehicles, such as CFD or a leveraged ETF. These instruments allow traders to multiply the scope of their funds through leverage. This carries risk which must be fully appreciated before attempting this type of trading. Traders look to profit from the change in price of the share and can trade both long and short positions which differ from physical share dealing. Leverage amplifies returns both positive and negative.
  • Stock ETFs and mutual funds: Give traders the opportunity to access a variety of stocks through both types of investments, offering an element of diversification that’s not usually available in only a single share or investment. Actively managed mutual funds give fund managers the ability to pick and modify stocks as they see fit, while many passive funds or passive ETFs allocate amongst investments and track that performance.

Investing in bonds

  • OTC traded bonds: Bonds are traded mainly over-the counter (OTC) which means they can be accessed through a broker, similar to a stockbroker. There are bonds that can be purchased directly from the government such as US treasuries, however, many banks do offer government bonds as well. These bonds cannot be traded short therefore are only available for purchase.
  • Leveraged bond trading: Many brokers offer treasuries to trade via leverage. These will differ from broker to broker. This is largely related to government bonds such as US treasury bonds and not corporate or municipal bonds. This type of trading is centered around the price change of the bond and can be traded both long and short.
  • Bond ETFs and mutual funds: These are similar to stock ETFs and stock mutual funds. The principal of fund managers passively (ETFs) and actively (mutual funds) managing portfolio components remain the same.

Brokerage and trading fees need to be researched before making any investment in stocks or bonds. This part of the investment process is often overlooked. Be sure locate a reputable broker with transparent fees.

With regard to leveraged products, the risks involved are far greater with more complexities behind trading fees and commissions. Respectable brokers usually have dedicated page outlining charges.

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Stocks vs bonds: A summary

There are several differences between stocks and bonds and choice of investment will depend solely on risk appetite and financial constraints. As a rule of thumb, investors who are risk-averse should lean towards a bond heavy portfolio while risk-seeking individuals will prefer stocks. Leverage changes this outlook as leverage trading as a whole will suit risk-seeking investors as risk-averse investors generally stay away from derivative trading.

Once investors understand their financial goals and budget restrictions, they may have a clearer view on the types of investment vehicles that would appeal them.

Stocks vs Bonds FAQs

Stocks vs bonds vs mutual funds?

Many investors also like to compare stocks, bonds with mutual funds. Mutual funds are financial securities whereby funds are assembled to invest in a range of financial instruments – stocks, bonds and other instruments. These mutual funds are actively managed regardless of the instrument involved as fund managers attempt to outperform the market. This differs from ETFs, which are usually passively managed, and individual stock and bond investing.

Can you lose money in bonds?

Investors can gain a return from bond investing via the interest payments (coupon) and, potentially, by selling the bond for more than the purchase price. A loss can be made if the bond issuer defaults on the payments or selling the bond for less than the purchase price. This translates to bond ETFs and bond mutual funds as well. This being said, bonds are generally publicized as one of the safer investment options as the probability of default is relatively low, particularly for ‘investment grade’ bonds, while stock returns are generally more variable based upon market dynamics.

Further reading on stocks, bonds and ETFs

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